A Surging Wave of Alternatives

November 14, 2014

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Now might be the time, you think, to jack up their exposure
to alternative investments. Hedge funds can be used for so many defensive
reasons: income without duration risk, steady growth with downside protection,
or as a low-volatility hedge against inflation. If only they weren’t so
expensive. If only the minimums weren’t so high. If only the lockups weren’t so
long.

That’s old-school thinking, of course. It ignores the wave
of liquid alternatives that may soon enough become a tsunami. There were about
100 alternative mutual funds launched last year alone. They feature lower fees
and lack many of those infuriating wrinkles, like gates, that drive clients nuts.
And some of the new products are even tax-sensitive.

Jason Schwarz, president of Wilshire Funds Management, says
the current exposure to alternative mutual funds is hovering around the 2% mark
out of approximately $15 trillion in mutual fund assets. That figure is headed
up. That we get to 10% over the next five years is certainly plausible. Ten
percent means that mutual funds employing alternative strategies would reach
$1.5 trillion by the year 2019.

Bob Rice, managing general partner of Tangent Capital
Partners, wrote a book on the subject, “The Alternative Answer,” and divides
them into three categories.

The first is “statutory.” It includes well-known vehicles
like “business development companies, master limited partnerships, and royalty
trusts.” The second includes active managers whose investment styles have long
been associated with hedge funds. Mr. Rice referenced Neuberger Berman’s Long
Short Fund as an example. The third category of liquid alternatives is
“passive.” He doesn’t mean passive like plain-vanilla index funds tied to a
slice, big or small, of the stock market. He means they follow formulas,
sometimes quite complex ones, designed to take advantage of market conditions.

Why go for a fund that is tied down by a formula? Cost is
one reason. There are now 10,000 hedge funds. With that much competition, it’s
exceedingly hard to stay ahead. All too often, the old 2-and-20 pricing means
that investors are “paying alpha fees for beta performance.”

In contrast, annual expenses in IndexIQ’s family of ETFs
range from 75 to 90 basis points. In classic merger arbitrage, for example,
managers short the acquiring company. Borrowing shares is the first step of any
short. But borrowing the shares of one company can be tricky--especially if
there are cash inflows and outflows while the fund is putting on the trade.

Before you’re seduced by low fees, ready liquidity and by
the continuing arrival of big-name managers, make sure you’ve got a real handle
on how the liquid alternatives work.